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Acquisitions, HUD Loans and the Transfer of Physical Assets Process

Due largely to its attractive long-term and non-recourse features, approximately 1,650 senior living facilities have been financed through the U.S. Department of Housing and Urban Development (HUD)/Federal Housing Administration’s (FHA’s) Office of Healthcare Programs (OHP) since 2009. These facilities carry loans that have historically low interest rates that are fixed for up to 40 years from their funding date.

With so many properties nationwide having HUD loans (Figure 1) it is important for an acquirer to understand HUD loan features to determine if assuming the loan fits with their operating model. One must use the process known as the transfer of physical assets (TPA) in order to keep an acquired property’s HUD/FHA financing. The TPA process requires the approval of the incumbent lender and HUD.

 

Understanding the HUD Loan

HUD loans have several features that are important for the acquirer to understand:

  • Interest rate: The loans have a fixed interest rate for the term of the loan. Through the TPA process, the acquirer assumes the loan with its current terms.
  • Mortgage insurance premium (MIP): In addition to the interest rate, the borrower pays HUD MIP to insure the loan principal to the holder of the note in the event the borrower defaults. Depending on the age of the loan and whether it was a construction or refinance loan, MIP ranges from 0.45% to 0.77% of the average annual outstanding balance on the loan. 
  • Lockout/prepayment penalty: Most HUD loans have a lockout/prepayment penalty for up to 10 years. This carries over to the new owner through the TPA process. The majority of HUD loans have a 10 year prepayment step down (example: lockout in year one, 9% prepayment penalty in year two, 8% in year three, 7% in year four, etc.). This structure typically provides the lowest rate for the borrower at the time the loan is closed.

HUD Replacement Reserves

HUD loans have a funded replacement reserve account. In the event of a change of ownership through a TPA, the replacement reserve balance will have to be either transferred to the new owner or replenished by the new owner. The new owner is also required to continue monthly contributions to the replacement reserve account. This monthly contribution varies from project to project as determined by a property capital needs assessment (PCNA), which analyzes the capital needs of the asset over a 20-year period.  Understanding how much needs to be funded in this account is important when the acquirer is considering the excess cash flow the property will produce.

Accounts Receivable and Deposit Accounts

If the acquirer uses accounts receivable financing the accounts receivable lender will have to comply with HUD’s requirements. The accounts receivable line between HUD properties and non-HUD properties, and the legal documents required by HUD, are different than what some accounts receivable lenders typically require.

The deposit accounts on a HUD property require specific lockbox-like features. For example, the facility is required to have a deposit account control agreement on the operating account and a deposit account swap agreement on the account that receives governmental reimbursement. While many depository institutions are now familiar with HUD’s requirements, there may be additional costs for these accounts that the acquirer will want to understand.

Reporting Requirements

The operator is required to submit quarterly financial statements and the owner is required to complete an annual audit on the property company. These reports are also submitted to the HUD lender.

Insurance Requirements

HUD requirements for the insurance carried on the facility may differ from the coverage the acquirer currently carries on its facilities. Additional costs to comply with HUD requirements should be understood before beginning the TPA process. The HUD lender can help the acquirer understand the differences between its current coverage and HUD’s requirements.

Third Party Operator

If the acquirer has a third party operator, this operator will have to comply with the HUD requirements discussed in this article. The acquirer will own the real estate and be required to fund the replacement reserve account and insurance escrows. As with most leases, the operator is responsible for these operational costs. The lease needs to be clear on the process by which the owner and operator obtain the funds for those payments.

HUD and Secondary Financing

With the exception of the FHA Sec. 241(a) supplemental loan program, HUD does not permit a second mortgage, which can sometimes make it challenging to acquire a HUD facility because of the equity required to complete the acquisition (i.e., difference in loan balance vs. acquisition cost). HUD will allow a surplus cash note taking the total indebtedness up to 92.5% of the property value. In some cases, a lender can structure the transaction with a TPA of the HUD loan and the seller carrying a surplus cash note for part of the acquisition cost that helps reduce the equity contribution at closing from the acquirer.

In cases where the acquirer is making significant operational changes to improve operations, it may make more sense for the acquirer to pay off the HUD loan at closing. By doing so, the acquirer can improve operations and valuation of the facility before refinancing with HUD at a later time for a loan amount greater than the original HUD debt. 

Unique Situations

There are some situations where it may make sense for an acquirer to complete a TPA in conjunction with a HUD refinance of the facility using the FHA Sec. 223(a)(7) program. 

  • If the facility is in need of extensive repairs, the acquirer can increase borrowing back up to the original HUD loan balance to fund those repairs. In some situations the term of the loan can also be extended.
  • If the facility is a distressed asset, the acquirer can access funds for some repairs and extend the term of the loan up to the lesser of 12 years or back to the length of the original loan. This can help an acquirer improve cash flow and fund repairs while turning around the facility.

Cost and Timing

HUD requires a TPA application fee of 0.05% of the original amount of the loan. In addition, there will be a lender’s fee to cover the cost for preparing the application, as well as legal costs to complete the necessary HUD legal work. It generally takes three-to-six months from start to finish to complete the TPA process.  

FHA indebtedness carries many attractive characteristics, such as non-recourse, a low cost of capital, and a term of up to 40 years, which acquirers should strongly consider when purchasing a senior living facility. However, as outlined above, the TPA process has many nuances that need to be considered during an acquisition process. Selecting a lender or adviser that can properly structure FHA debt on the front end and execute the TPA process on the back end can help avoid some of the common pitfalls, getting buyers and sellers to the closing table more quickly.

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